First Quarter 2019
The leading economic data shows little sign of an impending recession. Sinking financial markets seem to disagree. Admittedly, growth is slowing, but the markets often exaggerate economic concerns. Paul Samuelson, a Nobel laureate, once quipped that the stock market is such a great predictor of the economy that it has forecast nine of the last five recessions. Clearly, slowing growth need not end in recession. And given the extremely tight labor markets, some slowing would even be good for the economy. Thus, while the financial markets have put us on alert, we need to see other confirmations before we would put high odds on a major economic contraction.
Strong consumer spending in the second and third quarter of 2018 provided significant support for gross domestic product (GDP) growth. Without additional tax cuts, that source of spending growth will wane. However, if strong labor markets support confidence and income growth, spending should remain a cornerstone of solid economic growth.
Industrial activity and capital spending are particularly sensitive to fears of declining economic growth. Thus, economic anxiety has undoubtedly slowed manufacturing production and investment spending. If economic growth proves more sustainable than businesses currently fear, industrial activity may stage a solid rebound in the coming months.
Inflation has subsided modestly, but wage inflation could become a problem. Shortages of skilled labor remain a primary problem for business. Slower growth could take pressure off potential wage inflation. Although labor-saving investments offer a longer-term solution, investment is often postponed when businesses anticipate substantial economic slowing.
Some investors fear that the Federal Reserve (Fed) has already pushed rates too high. While it seems unlikely that major economic damage has been done yet, there is arguably more risk when the economy is already slowing. Recent Fed statements have been more reassuring, but it will take time for investors to regain confidence that economic growth will continue.
Consumer spending made a major contribution to the strong economic growth of the second and third quarters last year. Consumer spending added 2.4% of the 3.4% GDP growth in the third quarter, after adding 2.6% to the second quarter’s 4.2% GDP growth.
For 2018, spending grew in line with accelerated after-tax income because of tax reductions. Spending growth should therefore moderate as incomes slow back in line with pre-tax income growth. Pre-tax income rose 4.2% over the last year, which matches the growth rate since 2009. Spending growth may outpace that modestly if consumers remain confident and are willing to dip into savings. But the 5.7% annualized growth we saw over the last eight months is probably not sustainable given current income growth.
Also, consumer confidence has softened as equity markets have plunged. Worries about the economy and about the market decline itself have made consumers feel less secure about the future. Yet consumer confidence rests heavily on job security, and the availability of jobs in tight labor markets should help sustain confidence.
Although retail sales turned down at the end of the third quarter, shoppers recovered in the fourth quarter with strong October spending and solid holiday season buying. Spending on housing has slowed as affordability has declined, and auto sales have plateaued. On the other hand, increased spending in areas like apparel, footwear, and dining has helped fill the gap.
The prospect of slower domestic growth and the uncertainties of international trade have weighed on industrial activity. After a strong third quarter, industrial production got off to an uneven start in the fourth quarter. Strong utility production helped, and crude production continued to fuel industrial activity, but falling oil prices reduced new drilling, and manufacturing got a weak start in the fourth quarter. Capital spending proved particularly disappointing, as investment spending slowed over 2018, despite improved tax incentives.
The US Markit Purchasing Manager Index (PMI) confirmed the manufacturing slowdown, as that measure fell to 53.8 in December.
Inflation has been nicely restrained, and lower energy prices should reduce inflation pressures even more. Falling energy costs both reduce the headline inflation rate and help lower (lagged) core prices by reducing the pressure on goods with a high energy content.
The Personal Consumption Expenditure (PCE) indices, the Fed’s favorites, show how tame the inflation statistics have been. The headline index rose 1.8% year over year (YOY), below the Fed’s long-term target of 2.0%. And the core index, which excludes food and energy, rose 1.9% YOY. Service prices rose 2.5% YOY, although even that rate has moderated. Combined with falling durable goods prices and slowing increases for nondurable goods, inflationary pressures seem to have eased.
Yet wages continue to climb. Average hourly earnings in goods-producing industries rose 3.5% YOY in December. The average for that statistic in 2018 was 3.4%, up from an average of 2.6% in 2017. Likewise, earnings for service industries rose 3.3% YOY in December, with an average of 2.7% in 2018 and 2.3% in 2017. With productivity increasing 1.3% over the last year, wage increases above 3.3% should begin pressuring either inflation or profits.
Trade and Overseas Economies
World economies are still growing, but at a slower pace. Trade conflicts have not helped, but the slowing began months before tariffs were formally announced. In the fourth quarter, purchasing manager (PMI) readings have declined for roughly two-thirds of the economies followed.
Eurozone GDP growth softened again in the third quarter, to a 1.6% YOY gain. That is still consistent with the 1.4% annualized growth the Eurozone recorded since 2009, but the slide may not be over. The December Markit PMI declined another 1.7 points in the fourth quarter, falling to a modest reading of 51.4. That shows manufacturing is still expanding, but at a relatively slow rate. Part of the weakness this year stems from retooling to meet auto emissions standards, which should allow some recovery. The region also benefits significantly from oil prices. Yet, there is little evidence the downtrend is turning.
UK GDP growth rose to 1.5% YOY in the third quarter, somewhat below the 1.9% annualized increase since 2009. The Markit PMI stands at a still-solid 54.2, having improved 0.4 points in the fourth quarter. Admittedly, however, Brexit’s pressure on the UK currency has probably been better for exporters than for other parts of the economy. Unfortunately, progress toward agreement on the terms of Brexit seems to have bogged down.
Japan’s GDP grew only 0.1% in the third quarter, well below the 1.3% annualized growth since 2009. Japan tends to experience wider swings in growth than other countries, however, so the low figure is still within the range that country has experienced over recent years. The 52.4 December PMI reading also suggests fourth quarter growth could be somewhat stronger.
The drop in China’s PMI to 49.7 in December dismayed the financial markets. That is the first PMI confirmation of an actual contraction in Chinese manufacturing. While the composite Manufacturing PMI for the emerging region still hovers only marginally above the breakeven score of 50, emerging countries dominated the list of countries reporting improved PMI readings in the fourth quarter.
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